Who Wants to Trade With High-Frequency Traders?

No sane individual wants to take on a professional wrestler like The Rock. Similarly, no sane fund manager wants to trade on an exchange with an HFT fund.

Michael Lewis, author of Flash Boys, and Wall Street's high-frequency traders, have found themselves in a very public media war.

It wasn't Lewis's first exposé about Wall Street. Way back in 1989, he wrote a legendary introductory guide to Wall Street titled Liar's Poker. Lewis's first book opened the door on Salomon Brothers and the famous showdown between the firm's Head Bond Trader, John Meriwether, and the firm's CEO, John Gutfreund, during the 1980s -- a time in which many considered Salomon Brothers the most elite firm on the street. More recently, Lewis received national fame for his book Moneyball, which documented the extraordinarily successful adoption of statistical analysis in the Oakland Athletics front office. Most recently, Flash Boys has made the general public become aware of the significant advantages high-frequency trading has in the exchanges over the traditional investment fund.

Beyond talking about the advantages that HFT traders have, Lewis has emphasized that many small investors have been scared away from the markets. Many of these investors would have normally invested in the stock market. The funny fact is that retail investors -- those that buy small amounts of shares and generally use limit orders -- will actually find cheaper executions because the bid and ask spreads are narrower as a result of HFT.

Ironically, it is the large fund mangers, such as Fidelity Investments and T Rowe Price, that will suffer the most from HFT. The large buy and sell orders of the huge financial institutions will be detected by extremely fast HFT traders. When the HFT traders detect the institutional orders, their systems "top" offers on either side of the trade. This practice causes the large institutional orders to be "swarmed," which in turn causes worse execution prices and millions of lost investor dollars. The term "swarming" means that when the financial institutions are selling shares the HFTs will short the stock and when the large institutions are buying shares, the HFTs will buy shares in the same security and drive up the price. Of course, the HFT funds' investors will pick up those losses as gains, but why should the mutual funds or the value funds put up with this? Independent exchanges that do not allow HFT trading to occur offer a fantastic value proposition to any long-term institutional fund manager.

I believe in a free society and therefore would never consider the idea that HFT should be banned from the marketplace. Smarter computers allow for better products and better results. But if you look at other industries, unfair advantages are not permitted. Steroids also allow for better play and better results in sports. But, steroids have been banned in many leagues and the NCAA due to the advantage they have given certain players. Maybe some exchanges that want to appeal to the public should consider banning trading practices that hurt investors, just the way steroids have been banned in sports?

There will always be a place for steroids (thank you, World Wrestling), and maybe there should always be a place for HFT in our markets. But just the way no sane individual wants to take on a professional wrestler like The Rock, no sane fund manager wants to trade on an exchange with an HFT fund.

Alexander Fleiss serves as Chairman and Chief Investment Officer of Rebellion Research Partners LP, a Global Macro hedge fund and financial advisory that invests across all asset classes and is based in New York. Mr. Fleiss also oversees the firm's institutional research ... View Full Bio

I think the comparisons of HFT athletes using steroids is very apropos and I agree with much of what you said. However, steroids are illegal substances, as you point out. HFT firms are using public data feeds -- and pumping them through faster ticker plants, switches, fiber and microwaves. Exchanges (regulated entities) are providing the feeds. So unlike steriods, these are legal substances. Even the head of the SEC, Mary Jo White, recently said that HFT trading is not front running since they are using publicly available market data. Exchanges argue that the feeds are available to the buy side.Yet the buy side isn't necessarily interested in trading at the speed of light.

As for why the buy side would put up with this, apparently some of them are reaping the benefits of lower trading costs and tighter bid/offer spreads. Yesterday, Cliff Assness of AQR, a prominent quantitative asset manager, published a lengthy defense of HFT. In this piece, "High Frequency Hyperbole, Part Deux."

In this article, Asness and his colleagues claim that HFT firms are not front-running — they can't see any marketable orders ahead of time —rather they are making educated guessese, or practicing"order anticipation."

Asness points out that HFT cannot see marketable orders - orders at or above the offer to buy a stock, or orders at or below the bid to sell a stock- because U.S. exchanges do not provide this information. [Flash orders showing marketable orders were eliminated by US exchanges in August 2009.] He claims that HFT firms are only seeing matched trades and prices.

"...if HFTs did buy ahead of this investor on the other exchanges, that would not be considered front running. The HFTs were only making educated guesses," he wrote. When they cancel their orders on multiple exchanges, this is similar to someone putting up an item to sell on eBay and Craigslist. If one item is sold, they remove all their other items, because they only had one to sell in the first place. Is this deceptive, isn't it?

Unlike these authors, I think most of the buy side doesn't want to trade with high frequency firms, and that's why there are 30-40 dark pools. But HFT are also swimming in the dark pools, so they have developed defensive tactics.

It wasn't all bad luck for the capital markets this week: Hedge funds had a decent first quarter despite a slowdown in jobs numbers, BlackRock might be heading into new territory as hedge fund managers take a hard look at their counterparties, and the head of the IMF didn't pull any punches when assessing today's global economy. At least we can admire the nice weather and some of the best quotes of the week.